Europe seeks back-up plan for troubled banks within weeks

By John O'Donnell and Huw Jones

4 Min Read

The headquarters of the European Central Bank (ECB) are pictured in Frankfurt June 6, 2013.Ralph Orlowski

BRUSSELS (Reuters) - European states need to spell out by late November how they will cope with recapitalizing troubled banks to pave the way for prompt health checks, EU leaders will pledge this week, according to a draft statement.

Such a commitment is designed to persuade investors that countries are ready to come clean on the banking problems that continue to dog the region after more than half a decade.

On October 24 and 25, leaders from the European Union's 28 member states gather in Brussels. They will take stock of the EU's most ambitious project since the creation of the euro to set up a banking union to help growth and prevent future crises.

Unlike in the United States, where rapid infusions of capital put its banks quickly back on track, Europe's financial system remains frozen, with lenders in countries such as Greece, Spain and Italy hurt by weak demand and soured loans.

To break the "doom loop" between indebted European countries and their banks and reassure investors that stressed euro zone lenders would be dealt with on a regional level, a banking union, with the ECB as supervisor, is seen as crucial.

The ECB will test the health of the largest euro zone banks to make sure none are too weak to operate, but if countries do not have the money to raise their capital if needed, the exercise would hurt, rather than boost investor confidence.

In a draft statement from the leaders, they commit to addressing this issue, by demanding that countries under ECB watch outline, within roughly five weeks, how they plan to help banks in trouble.

In the statement seen by Reuters, leaders emphasized the "urgency" of "establishing a comprehensive and coordinated approach in preparation for the comprehensive assessment of credit institutions by the European Central Bank".

"It should involve all appropriate arrangements, including national backstops," said the statement, referring to state-backed means to help a bank that cannot raise capital in other ways -- primarily from private investors.

Leaders will also underline that they want clarity as to how the euro zone's rescue fund will be able to provide aid directly to banks rather than via the government of their home country.

This is a central plank of the banking union as it would prevent banks from pushing their home country to the brink of bankruptcy, as in Ireland. This option is to become active once the ECB starts its supervisory duties in November 2014.

Yet ECB policymaker, Peter Praet, warned on Monday that the start-date could slip beyond November. Such a delay could rattle investor nerves.

For next year, euro zone countries will have to rely on their national backstops to finance the restructuring or winding down of banks that ECB finds short of capital. But under the banking union project there is to be a central euro zone fund, financed from bank contributions, to do that.

The ECB expects such a central fund, along with a central authority which could decide the fate of any euro zone lender, would be in place from the start of 2015, shortly after the central bank itself takes over its new supervisory role.

But the political will to forge full banking union has waned as the heat of the crisis has passed. To speed up the creation of the bank resolution authority, the European Commission has proposed that it itself would take on that role, but Germany rejects that.

This means that the ECB is preparing to take on its role from late next year in a dangerous vacuum.

The ECB, both for its own reputation and the future of the bloc, is under pressure to ensure that banks undergo a thorough health check that will force them to recognize hidden losses.

It will run the checks in an 'Asset Quality Review' that will in turn be used as a yardstick for wider testing of banks across the European Union.